Relationship between Leverage and Business Risk

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The risk of a firm is influenced by the use of leverage. Incurrence of fixed operating costs in the firm’s income stream increases the business risk or operating risk. It increases the variability of operating income due to change in sales revenue.

Similarly, employment of debt in the capital structure increases the financial risk. It increases the variability of the returns to the shareholders. So leverage and risk are directly related.

Leverage and Operating Risk:

Operating risk is the risk associated with the operation of the firm. It is a function of the operating condi­tions faced by a firm and the variability these conditions inject into the operating income and expected dividends. It arises out of the expected return on the total fund invested.

Rate of return is a random vari­able as it takes different values at different points of time. This return varies from the expected return and this variation leads to rise in business risk. As leverage magnifies this variation resulting into larger fluctuations in operating income it is associated with operating risk.

Leverage and Financial Risk:

Financial risk is the risk associated with financing decisions of the firm. It is a function of the financial planning of the firm. If a firm increases the proportion of debt capital in its capital structure, fixed charges increase.

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All other things being the same, the probability of the firm not being able to meet these fixed charges also increase. If the firm continues to lever itself, the probability of cash insolvency increases. Hence any decision to use debt or preferred stock in the capital structure of the firm means that the equity shareholders of the firm are exposed to financial risk.